Corporate profits are starting to feel the pinch of higher interest rates, but so far their stocks are holding up. Companies will need to grow those earnings, however, if they don’t want their shares to feel the pain.
Elevated interest rates have already cut into earnings: With most of the second-quarter results now in, per-share earnings are down just over 4% from the year-ago period for the S&P 500, according to Credit Suisse.
It isn’t just that revenue growth has been paltry, as the Federal Reserve has aimed to cool inflation with interest-rate hikes. But companies are also grappling with higher interest expenses on their debt. Firms refinancing any debt have to borrow at significantly higher rates compared with just last year.
Firms have seen rising interest coverage ratios, the ratio of operating profit to interest expense—this metric shows how well a company’s profit can cover its debt. Now, for every dollar of interest expense on the S&P 500, there’s $7.60 of operating profit, down from postpandemic peak of just over $10, according to Ned Davis Research.
That, in theory, should hit companies’ bonds—and ultimately their stocks. Higher borrowing costs make it harder for firms to pay their debts, which should hit the price of their bonds—and in turn lift the interest rate they can borrow at even further. That would pressure their equity valuations. (Corporate bonds and stocks generally move in the same direction because favorable conditions for companies both improve profits and make it easier for them to repay their debts.)
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But neither corporate bonds nor equities have felt much pain this year. The share price of the Shares iBoxx $ Investment Grade Corporate Bond Exchange-Traded Fund (ticker: LQD) is up about 0.6% this year, so investment grade bond yields are down a touch for 2023. Bond yields and prices move inversely.
Consistent with that, the stock market is up this year—the
has climbed 18% so far in 2023. The index continues to trade at a rich valuation, at just over 19 times analyst’s expectations for per-share earnings over the next 12 months, according to FactSet. That is essentially unchanged from March 2022, just before the Fed started lifting rates.
The reason for the high valuations: the market is confident in companies’ earnings. The hope is that, as the Fed stops lifting rates and the economy stabilizes, sales and profits will grow next year. In turn, operating profit growth could outgrow companies’ interest expense—analysts for S&P 500 companies in aggregate forecast operating profit growth of about 10% next year. That would improve companies’ ability to pay their debt and encourage investors to keep buying corporate bonds and stocks.
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Of course, the big risk here is that those earnings don’t pan out. Fed Chairman Jerome Powell said at the Jackson Hole Symposium in late August that the central bank might keep rates elevated at current levels for a while. The damage to the economy from higher rates usually happens on a delay, so many on Wall Street see more declines in economic growth, which could hold back profit growth. If companies miss profit expectations and their debt burdens remain largely the same, their stocks and bonds will likely finally get hit.
That means it all comes back to earnings, making the stakes even higher for companies to produce strong profits to keep their stocks chugging higher.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
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Read More: The Stock Market’s Debt Problem Is Hiding in Plain Sight
